BUS 101 Course Notes

Week 2 – Introduction to Accounting

What Do Accountants Do?

The accounting function involves the recording, classifying, summarizing and analysis of
data. Accountants can be broadly categorized as being either external or internal
accountants.

External accountants are charged with the responsibility of supplying third-party assurance to
financial statement users. They do not formally prepare the financial statements; however,
they do ensure that there is a sufficient amount of disclosure relevant to issues that may
impact a financial statement user’s decision.

Internal accountants are part of management’s support staff. They are charged with
compiling and interpreting information to aid in managerial decisions relating to all business
processes including purchasing and procurement, inventory management, sales and
marketing, corporate strategy, and product innovation.

Types of Accounting
Managerial accounting: Measures and reports financial information as well as other types
of information that assist managers in fulfilling the goals of the organization.

Financial accounting: Focuses on external reporting that is guided by Generally Accepted

Accounting Principles (GAAP) and Generally Accepted Auditing Standards (GAAS).
Generates or audit financial statements, such as the Balance Sheet, the Income Statement
or the Cash Flow Statement, which provide information to shareholders.

Cost accounting: Measures and reports financial and other information related to the
organization’s acquisition or consumption of resources. It provides information for both
management accounting and financial accounting.

Financial Statements
In the Bissan Case, we show you simplified versions of two main Financial Statements: the
balance sheet and the income statement.

Balance Sheet: This is a document that illustrates a company’s financial position at one
point in time. Think of it as a “snapshot” (photograph) of the account balances on a specific
date. It contains 3 sections. The assets are always listed on the left, and they are financed
either by liabilities (usually by borrowing) or equity (usually by selling stock / finding
investors). When you create your business plan, you will need to determine how your assets
will be financed.
o Assets: Items of economic value owned by the corporation, especially those which
could be converted to cash. Examples are cash, accounts receivable, inventory,
office equipment, a building, a vehicle, and other property.
o Liabilities: Financial obligations, debts, claims, or potential losses. In simple terms,
this usually means something that you owe to someone else, like the portion of a loan
you owe to the bank.
o Equity: Ownership interest in a corporation usually in the form of stock. Total assets
minus total liabilities. It is also called shareholder's equity or net worth.
Income Statement: This is a document that summarizes a company’s performance over
time. For a given period, it summarizes the revenues, expenses, and net income. A sample
Income Statement, similar to the one in the Bissan Bikes Case, is described below. Usually
we indicate numbers that will be subtracted as negative and surround them with brackets ( ).

Sample Income Statement

This is the total amount of
Revenue money earned by sales to
customers.
This is also called COGS. This
is the total amount spent on
production of goods. These
Cost of Goods
costs include Fixed and
Sold
Variable production costs, but
not Marketing or Administration
Costs.
This is the Revenue minus the
COGS. It is the profit not
Gross Margin
considering administrative
expenses or taxes.
This is money needed to run
Selling and
the company and earn the
Administrative
sales, but it is not directly
Expenses
related to production.
This is the total profit made
before taxes are paid. It is the
total of all the revenues minus
Income Before
the total of all the costs. We
Taxes
can use this formula here:
(Gross Margin) – (Selling and
Admin Expenses).
Income Tax This is the amount paid for
Expense taxes.
This is the final profit after taxes
Net Income
are paid.
For example, if we sell 8000
bikes for 600YTL each, our 4,800,000
Revenue will be (8000)*(600).
In our example, if it costs
415YTL to produce one bike,
(3,320,000)
then your COGS will be
(415)*(8000).
It will be (4,800,000) -
1,480,000
(3,320,000).
Usually our sales or marketing
department tells us how much
(896,400)
they spent. In this case they tell
give us the figure 896,400YTL.
This will be (1,480,000)-
(896,400). Calculating
(Revenue) – (COGS) – (Selling 583,600
and Admin Expenses), will yield
the same result.
We multiply the before tax
income by the tax rate. If our
(262,620)
tax rate is 45%, our income tax
expense is (583,600)*0.45.
(Before Tax Income) – (Income
Tax Expense) = (583,600) – 320,980
262.620.

Types of Costs
Direct Costs: Costs which are related to the production of a good that can be easily traced.
Some good examples are direct materials and direct labour because you can easily measure
what goes into the finished product.

Indirect Costs: Costs that are related to the production of a good but cannot be traced to it
in an economically feasible way. An example of an indirect cost is a rent or electricity
expense. You know that the money spent on these things was required to produce the
finished products, but conducting a study to determine how much electricity went into the
product would be expensive and likely not worth the bother. Indirect costs can also be called
overhead. Indirect costs are often allocated to using a cost allocation method such as “% of
labour” or “% of machine hours”.

Variable Costs: This is a cost that changes when production changes. For example, if the
tires of a bicycle cost a total of $15, then for every additional bicycle, the total cost of tires will
increase by $15.
Fixed Costs: Costs that do not change in total despite changes in production. An example is
the cost of building a new factory. Regardless of how many bikes we produce, this cost will
not change.

The following matrix summarizes the relationship between fixed, variable, direct, and indirect
costing:

Assignment of Costs
Direct Indirect
Cost Object: Assembled Cost Object: Assembled Automobile
Automobile. Example: Power costs to produce cars
Variable
Example: Tires used in where power usage is metered only to
Cost
assembly of automobile. the plant.
Behavior
Cost Object: Marketing Cost Object: Marketing department
Pattern
Department Example: Monthly charge by corporate
Fixed Example: Annual leasing cost computer centre for marketing’s share
of cars used by sales force of corporate computer costs.
representatives.
Cost Accounting: A Managerial Emphasis, Horngren et al., 2nd Canadian Edition, 2000.

Using “Cost Per Unit” Cautiously

If we assume that to produce 50,000 bikes, total variable costs are $3 million, and total fixed
costs are $1,000,000 we can describe the unit cost per each bike as being (1,000,000 +
3,000,000)/50,000 = $80. However, what happens when we change the level of
production?

If we double the number of bikes to 100,000 bikes, there will be no change in total fixed
costs, however there will be a change in total variable costs.

The unit cost per bike will now be (3,000,000*2 + 1,000,000)/100,000 = $70.

From this example, we can see why it is important to base business decisions on total costs,
rather than unit costs because the unit costs are often calculated based on an weighted-
average of fixed and variable costs.

Relevant Factors Which Influence Decisions

When making a decision, you must decide which factors are relevant and which are not
relevant. When considering costs and revenues, ask yourself this question: will my decision
impact this cost (or revenue)? For example, let’s say we want to decide whether or not to
produce more bikes. If a cost will increase with production, then it is relevant. If a cost does
not change when you produce more bikes, that cost does not need to be a factor in your
decision.

Relevant quantitative factors are outcomes that are measured in numerical terms. Some
quantitative factors are can be expressed in financial terms, such as the costs of direct
materials, direct manufacturing labour, and marketing. Other quantitative factors are non-
financial, such as the percentage of on-time flight arrivals for an airline company.

Relevant qualitative factors are outcomes that cannot be measured in numerical terms.
Employee morale, brand awareness, and reputation are some examples.
In the Bissan case, ask yourself which costs are relevant to the decision. Do direct materials
costs increase with production? Does total fixed overhead increase with production? In order
to decide how much value this increase in production (and sales) will add to our bottom line,
we only need to consider the costs that will change when we change production. Why?

Contribution margin

The contribution margin (CM) is the sales price minus all the variable costs (costs that
change when production changes), on a per unit basis. This indicates how much money the
sale of one more unit will contribute to the bottom line (profit). Why don’t we include fixed
costs in this calculation? Are they relevant to the decision?

Contribution margin is not the same as gross margin. Contribution margin is computed after
all variable costs have been deducted, whereas gross margin is computed by deducting cost
of goods sold from revenues.

Break-even point

This is the quantity of output at which total revenues equal total costs. At this point, the profit
is zero. The company has generated enough revenue to cover their fixed costs.

Profit = Total revenues – Total variable expenses – Total fixed expenses

Since revenues and variable expenses change with respect to the number of bikes sold, we
can re-write this equation and manipulate it to figure how many bikes need to be sold.

Profit = (Revenue per bike * number of bikes sold) –

(Variable expenses per bike * number of bikes sold) – Total fixed expenses

Profit = (bikes sold) * (Rev. per bike – Var. exp. per bike) – Total Fixed Exp.

Since (Rev. per bike – Var. Exp. per bike) is contribution margin (CM), we can write:
Profit = (bikes sold) * (Contribution Margin) – Total Fixed Expenses

The Break Even point is the number of bikes sold that will make the Profit = 0. So:
0 = bikes sold * CM – Total fixed expenses
Total fixed expenses = bikes sold * CM
Total fixed expenses / CM = bikes sold

Therefore, the break-even point is the level of output at which the contribution margin exactly
covers the total fixed costs. What is the reasoning behind this? Remember that your
contribution margin tells you how much profit is “contributed” by producing each bike.
However, if your revenues exceed your variable expenses, does this mean your company is
profitable? Not necessarily. Because the contribution margin does not take into account
fixed expenses, in order to “break-even” you must also ensure that you are making enough
profit per bike to cover these fixed costs.
 BUS 101 Course Notes
Week 3 – Further Analysis of Bissan Bikes Case

Cost of Inventory
Bissan Bikes is trying to decide whether or not to increase production. When production
increases, the amount of money spent on things like raw materials, direct labour, and
variable overhead also increases. By how much will these expenses increase, and does the
company have enough resources (cash) to complete this project (is it even feasible)? This
extra cash will be “tied up” in inventory. This means that the company will not be able to
spend it on anything else.

Stages of production
In order to calculate how much cash is needed to increase production, we need to break
production down into stages. A different amount of cash will be tied up at each stage.

Raw Materials Inventory: Also called Direct Materials Inventory, we will need to spend
money purchasing materials used in production, such as metal for the frame, components
like brakes from Shimano and accessories such as reflectors.

Work in Progress Goods: These are goods partially worked on but not yet fully completed.
The value of these is one half of all variable costs for the number of units at this stage.

Finished Goods Inventory: Goods fully completed but not yet sold. These goods are at the
factory awaiting shipment to a warehouse.

Inventory Stored in the Warehouse: These goods have been shippped to a storage
location but not yet sold.
Accounts receivable: Amounts owing by customers, usually arising from the sale of goods
or services. In the case of Bissan, accounts receivable would have risen because the goods
had been delivered and so revenue would have been recognized, but the customer (MikRos)
still owed cash. This money that we are waiting to receive from MikRos is still a “hole” in our
cash flow.

To determine the total additional investment required to produce the bikes, add up the
amount of money invested in each of the production stages. Now look at the Balance Sheet
to determine if the company has enough resources to take on this project. If there is not
enough cash, Bissan will need to borrow money.

Taking on Debt (Borrowing Money)

Interest
When you borrow money, over time you will also be required to pay interest on this money.
This is the price of borrowing money. Usually interest is expressed as a percentage, or rate,
such as 8%. For example, if you borrow 1000 YTL at an interest rate of 8%, you will owe
1000 YTL plus 1000*0.08 = 80 YTL worth of interest. This money that we need to spend in
order to borrow money is often referred to as the cost of funds.

Debt/Equity ratio = (total debt/total equity). This ratio gives an indication of the capital
structure of a firm. It tells us relatively how much its assets were derived from debt (liabilities)
as compared to equity financing. On the balance sheet, [assets = liabilities + equity]. There
is no “optimal” ratio here. What constitutes a “normal” debt/equity ratio is dependent on the
industry and financial climate of the firm. Intuition suggests that the less debt the better so
the best debt/equity ratio is zero.

But not so! A firm with a very low debt/equity ratio (near zero) may be very stable with few
creditors (lenders) to worry about paying back, but it may be missing opportunities by
refusing to take on debt. You can often earn more by borrowing and investing than by not
borrowing. For example, if a company is earning a 14% return on equity, and can borrow at
8%, then borrowing can allow the firm to grow and earn more income. This is called using
debt as “leverage”. You will learn more about this in MAN 213 and MAN 321.

Bank Loans and Restrictions

It is common for banks to use standard ratios, such as the Debt/Equity ratio, to place
restrictions on loans extended to firms. For example, a bank may place a restriction that
prevents the firm’s Debt/Equity ratio to fall below 0.5. The bank does this because it wants to
make sure that the company has sufficient assets to repay the loan. Typically, a violation of
such a restriction is illegal and the bank will require the company to pay back the entire loan
right away.

Opportunity Cost
The contribution to income that is sacrificed because you are not using a limited resource
such as cash in its best alternative use. As yourself this question: if you didn’t use the cash
to invest in this project, what else could you do with it? Could you have invested in a
different project? Could you have earned a higher rate of return on a different investment?

Cannibalization

The risk of losing sales of an existing product because a new product is entering the same
market. For example, if you sell regular toothpaste and then decide to introduce consumers
to whitening toothpaste, your new product will probably hurt the sales of your older product.
Summary
After completing this Case Study you should have developed an understanding of the
following concepts:

 Some costs are variable and vary with production while others are fixed and remain
constant regardless of production levels.
 Some costs are relevant and some are not relevant to a “produce or don’t produce”
situation.
 Inventory is not free. Increasing production ties up cash in inventory and accounts
receivable, and you need to determine whether you can afford to do this.
 Borrowing money is not free. Along with debt comes interest expense.
 By investing cash in a new project, you are sacrificing the income you could be earning if
you invest that money in a more lucrative (profitable) investment. This missed opportunity
is called “Opportunity Cost.”
 If a company does not have enough cash or available financing to produce the initial cash
needed for a project, the project will not go forward.
 A company has resource limitations such as production capacity. We cannot produce an
infinite number of products.
 In addition to looking at revenues and expenses, strategic and qualitative factors must be
considered when making any decision. Although financial analysis can add to our
understanding of a scenario, a decision cannot be made blindly by the numbers. Are the
numbers are telling use everything, or leaving something out? Ultimately you need to use
your common sense and reasoning.
English – Turkish Glossary
accounts payable: ticari borçlar
accounts receivable: ticari alacaklar
administrative expenses: idari giderler
annual volume: yıllık hacim
assets: varlıklar, aktifler
average unit cost: ortalama birim maliyet
balance sheet: bilanço
bank indebtedness: banka borcu
capital: sermaye
Capital Markets Board (CMB): Sermaye Piyasası Kurulu (SPK)
cash flow statement: nakit akışı tablosu
cost: maliyet
cost of goods sold: satılan malın maliyeti
current assets: cari aktifler, dönen varlıklar
current liabilities: kısa vadeli borçlar
debt: borç
debt ratio: borç oranları
dividend: kar payı
equity: özvarlık/özsermaye-özkaynak
expense: gider
finished goods: mamul mal
gross margin: brüt kar
income before tax: vergi öncesi kar
income statement: gelir tablosu
income tax: gelir vergisi
independent accountant: serbest muhasebeci
independent account financial advisor: serbest muhasebeci mali müşavir (SMMM)
leasing: finansal kiralama
liabilities: borçlar
net income: net kar
net sales: net satışlar
net worth: özsermaye
overhead cost: sabit maliyetler
prepaid expenses: peşin ödenen giderler
principal: ana para
property plant and equipment: maddi duran varlık
raw materials: hammadde
retained earnings: dağıtılmamış karlar
return on equity: özsermaye karlılık oranı
revenue: gelir
sales: satışlar
stockholders or shareholders or owner’s equity: özsermaye
unit cost: birim maliyet
unit price: birim fiyat
work-in progress: yarı mamul

Resource: Akman, N. & Muğan, Can. (2005). Principles of Financial Accounting. Ankara:
Gazi Kitabevi